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Before selecting a stock, there are a number of things that you need to consider in order to ensure that you are buying the stock of a high-quality company whose shares are poised to grow in value over time. Some of these concerns include what the company does, its competitive advantages, valuation, dividend payouts and sustainability, and earnings consistency.

Another important thing that you need to consider is the financial condition of the company in question. You want to know if the company is able to continue paying its bills, and how much debt it carries. The balance sheet is one of the most effective tools that you can use to evaluate a company's financial condition. In this article, I will discuss the balance sheet of IBM IBM in order to get some clues as to how well this company is doing.

I will go through the balance sheet, reviewing the most important items, in order to assess the financial condition of IBM. The information that I am using for this article comes from IBM's annual report for 2012, which can be found here. Note that this article is not a comprehensive review as to whether IBM should be bought or sold, but rather, just an important piece of the puzzle when doing the proper due diligence.

This article might be a bit too basic for some and too long-winded for others, but I hope that some of you can derive benefit from it.

Background

International Business Machines Corporation is a powerhouse in the information technology industry. Its business is divided into five segments. The Global Technology Services segment provides information technology infrastructure and business process services, such as strategic outsourcing, integrated technology, and technology support services. This segment accounted for 38% of IBM's sales in 2012. Their Global Business Services segment provides consulting and application management services to businesses around the world. This segment contributed to 18% of the company's sales from last year. Their Software segment offers software that can be used to integrate and manage a myriad of business processes, as well as information management software, and data warehousing and analytics. This segment accounted for 24% of the company's 2012 sales. The Systems and Technology segment offers data storage, semiconductor technology, products, and packaging solutions, and much more. This segment is responsible for 17% of the company's 2012 revenues. And, finally, their Global Financing segment offers lease and loan financing to end users, as well as commercial financing to dealers and remarketers of information technology products. This segment provided 2% of the company's 2012 revenue.

IBM has a market capitalization of $230B and has recorded $105B in sales over the last 12 months. 44% of the company's sales came from the Americas, while 31% came from Europe, the Middle East, and Africa, and 25% of its sales came from the Asia-Pacific region.

Cash and Cash Equivalents

The first line in the Assets column of the balance sheet is for the amount of cash and cash equivalents that the company has in its possession. Generally speaking, the more cash the better, as a company with a lot of cash can invest more in acquisitions, repurchase stock, pay down debt, and pay out dividends. Some people also value stocks according to their cash positions. Some of the larger and more mature companies tend not to carry a lot of cash on their balance sheets, as they might be more inclined to buy back stock with it, or pay out dividends.

As of Dec. 31, 2012, IBM had $11.1B in cash and short-term investments, which can be easily converted into cash. Over the last 12 months, IBM paid out $3.77B in dividends, and bought back $12.0B worth of stock. The company still has an authorization to repurchase up to $8.65B worth of stock under its current program. IBM expects to finance these buybacks with cash from operations. When it comes to dividends, while the stock is only yielding 1.7%, IBM has increased its dividend every year for the last 17 years. Over 2012, the company has generated free cash flow of $15.5B.

Net Receivables

Receivables constitute money that is owed to a company for products or services that have already been provided. Of course, the risk with having a lot of receivables is that some of your customers might end up not paying. For this reason, you usually like to see net receivables making up a relatively small percentage of the company's sales.

IBM had a total of $30.6B in net receivables on its balance sheet, which represents 29.1% of its 2012 sales of $105B. For 2011, 27.7% of its sales were booked as receivables, while that percentage was at 29.8% for 2010.

While 29.1% might be considered a relatively high percentage for receivables, it appears to be pretty consistent with the company's history over the last couple of years, so I'm not too worried about this.

Current Ratio

Another factor that I like to look at is the current ratio. This helps to provide an idea as to whether or not the company can meet its short-term financial obligations in the event of a disruption of its operations. To calculate this ratio, you need the amount of current assets and the amount of current liabilities. Current assets are the assets of a company that are either cash or assets that can be converted into cash within the fiscal year. In addition to cash and short-term investments, some of these assets include inventory, accounts receivable, and prepaid expenses. Current liabilities are expenses that the company will have to pay within the fiscal year. These might include short-term debt and long-term debt that is maturing within the year, as well as accounts payable (money owed to suppliers and others in the normal course of business). Once you have these two figures, simply divide the amount of current assets by the amount of current liabilities to get your current ratio.

If a company's operations are disrupted due to a labor strike or a natural disaster, then the current assets will need to be used to pay for the current liabilities until the company's operations can get going again. For this reason, you generally like to see a current ratio of at least 1.0, although some like to see it as high as 1.5.

The current ratio of IBM is 1.13, which is pretty decent.

Property, Plant, and Equipment

For a company to operate in any industry, a certain amount of capital expenditure is required. Land has to be bought, factories have to be built, machinery has to be purchased, and so on. However, less may be more when it comes to outlays for property, plant, and equipment, as companies that constantly have to upgrade and change its facilities to keep up with competition may be at a bit of a disadvantage. However, another way of looking at it is that large amounts of money invested in this area may present a large barrier-to-entry for competitors.

Right now, IBM has $14.0B worth of property, plant, and equipment on its balance sheet. This figure is inline with the $13.9B that it reported at the end of 2011, and the $14.1B that the company reported at the end of 2010. In its 10-K filing, the company said that 73% of that money is in plant, laboratory, and office equipment. The remainder is mostly in buildings. Given the steadiness of this figure over the last three years, I don't see much to worry about here.

Goodwill

Goodwill is the price paid for an acquisition that's in excess of the acquired company's book value. The problem with a lot of goodwill on the balance sheet is that if the acquisition doesn't produce the value that was originally expected, then some of that goodwill might come off of the balance sheet, which could, in turn lead to the stock going downhill. Then again, acquisitions have to be judged on a case by case basis, as good companies are rarely purchased at or below book value.

IBM has $29.2B worth of goodwill on its most recent balance sheet, which is higher than the $26.2B that the company reported at the end of 2011, as well as the $25.1B that they reported at the end of 2010. Of the $3B increase in 2012, $2.89B came from 11 acquisitions that the company made in 2012 for a total consideration of $3.96B. The biggest acquisition of 2012 for IBM was the $1.35B purchase of Kenexa, which is a provider of recruiting and talent management solutions, as well as cloud-based technology and consulting. The goodwill involved with this one transaction was $1B. The $1.1B increase in goodwill from 2010 to 2011 was due to 5 acquisitions that the company made in 2011 for a total consideration of $1.85B.

Over the last 10 years, IBM has acquired over 100 companies.

Overall, goodwill accounts for a whopping 24.5% of IBM's total assets of $119B. Usually, I don't like to see goodwill account for more than 20% of a company's total assets for the reason that I discussed above. For this reason, I would be a bit concerned when it comes to the possibility of writedowns in goodwill in the years to come, and what that might do to the stock price.

Intangible Assets

Intangible assets that are listed on the balance sheet include items such as licensed technology, patents, brand names, copyrights, and trademarks that have been purchased from someone else. They are listed on the balance sheet at their fair market values. Internally-developed intangible assets do not go on the balance sheet in order to keep companies from artificially inflating their net worth by slapping any old fantasy valuation onto their assets. Many intangible assets like patents have finite lives, over which their values are amortized. This amortization goes as annual subtractions from assets on the balance sheet and as charges to the income statement. If the company that you are researching has intangible assets, with finite lives, that represent a very large part of its total asset base, then you need to be aware that with time, those assets are going to go away, resulting in a reduction in net worth, which may result in a reduction in share price, unless those intangible assets are replaced with other assets.

IBM currently has $3.79B worth of intangible assets on its balance sheet. Most of these assets are in completed technology and in acquired client relationships. Due to the fact that intangible assets only represent 3.2% of the company's total assets, I don't see much to be concerned about here.

Return on Assets

The return on assets is simply a measure of the efficiency in which management is using the company's assets. It tells you how much earnings management is generating for every dollar of assets at its disposal. For the most part, the higher, the better, although lower returns due to large asset totals can serve as effective barriers to entry for would-be competitors. The formula for calculating return on assets looks like this:

Return on Assets = Net Income / Total Assets.

For IBM, the return on assets would be $17.6B in core earnings over the last 12 months, divided by $119B in total assets. This gives a return on assets for 2012 of 14.8%, which is really good, especially when considering that a huge asset base of $119B serves as a good barrier-to-entry. I also calculated IBM's returns on assets over 2011 and 2010 for comparative purposes. This can be seen in the table below.

Symbol

2012

2011

2010

IBM

14.8%

14.1%

13.1%

Table 1: Decent Returns On Assets From IBM

These are good returns on assets that are fairly consistent, and they are slowly rising. This is because the company's earnings are rising faster than its asset totals, showing that management is being more efficient with the assets that it has available.

Short-Term Debt Versus Long-Term Debt

In general, you don't want to invest in a company that has a large amount of short-term debt when compared to the company's long-term debt. If the company in question has an exorbitant amount of debt due in the coming year, then there may be questions as to whether the company is prepared to handle it.

IBM has a total of $9.18B in short-term debt, of which $5.59B is original long-term debt that will be maturing within the fiscal year. This large amount of short-term debt concerns me a little bit. Given the current interest rate environment, the company may refinance at least some of this debt out to later years. They might also dig a bit into their cash position to help pay for some of it.

IBM also has $12.0B of deferred income in the liabilities section of its balance sheet. This figure represents money that the company received for products and services that the company has yet to provide. This figure will be whittled down as the company makes good on its commitments here, as those products and services are delivered.

Long-Term Debt

Long-term debt is debt that is due more than a year from now. However, an excessive amount of it can be crippling in some cases. For this reason, the less of it, the better. Companies that have sustainable competitive advantages in their fields usually don't need much debt in order to finance their operations. Their earnings are usually enough to take care of that. A company should generally be able to pay off its long-term debt with 3-4 years' worth of earnings.

Right now, IBM carries $24.1B of long-term debt. This is higher than the $22.9B that it carried one year before, as well as the $21.8B that they carried at the end of 2010. Of the company's long-term debt, $7.35B is due over the next four years, while some of it isn't due for decades. The average interest rate on this debt is 3.4%.

In determining how many years' worth of earnings it will take to pay off the long-term debt, I use the average of the company's core earnings over the last 3 fiscal years. The average core earnings of IBM over this period is $16.2B. When you divide the long-term debt by the average earnings of the company, here is what we find.

Years of Earnings to Pay off LT Debt = LT Debt / Average Earnings

For IBM, here is how it looks: $24.1B / $16.2B = 1.49 years

This is a very good number for IBM, in that it can pay off its long-term debt with an amount that is equal to 18 months worth of company earnings. Due to the earnings power of IBM, I believe that the company's long-term debt is very manageable.

Treasury Stock

In the equity portion of the balance sheet, you will find the treasury stock. This figure represents the shares that the company in question has repurchased over the years, but has yet to cancel, giving the company the opportunity to re-issue them later on if the need arises. Even though treasury stock appears as a negative on the balance sheet, you generally want to see a lot of treasury stock, as strong, fundamentally-sound companies will often use their huge cash flows to buy back their stock. For this reason, I will usually exclude treasury stock from my calculations of return on equity and the debt-to-equity ratio in the case of historically-strong companies, as the negative effect of the treasury stock on the equity will make the company in question appear to be mediocre, or even severely distressed, when doing the debt-to-equity calculation, when in reality, it might be a very strong company.

IBM, which we can all agree is a historically-strong company, has a treasury stock figure of $123B.

Debt-To-Equity Ratio

The debt-to-equity ratio is simply the total liabilities divided by the amount of shareholder equity. The lower this number, the better. Companies with sustainable competitive advantages can finance most of their operations with their earnings power rather than by debt, giving many of them a lower debt-to-equity ratio. I usually like to see companies with this ratio below 1.0, although some raise the bar (or lower the bar if you're playing limbo) with a maximum of 0.8. Let's see how IBM stacks up here.

Debt To Equity Ratio = Total Liabilities / Shareholder Equity

For IBM, it looks like this: $100B / $18.9B = 5.29

At first glance, this debt-to-equity ratio looks like something that would belong to a severely distressed company. However, let's dig deeper.

A variation of this ratio that I like to use strips out the negative effects that the presence of treasury stock has on the balance sheets of very strong companies (like IBM). A lot of strong companies don't need a lot of equity in order to operate and choose to dispense some of that equity with treasury stock through share repurchases that are intended to enhance shareholder value. When you take the treasury stock into account as a negative component of shareholder equity, the debt-to-equity ratio can make the company appear to be severely distressed when we all know that is not the case.

In this particular variation of the debt-to-equity ratio, I add the treasury stock back into the equity, as treasury stock can be re-issued at a later date if the need arises (although you hope that never happens). I call this ratio the adjusted debt-to-equity ratio. It's calculated like this:

Adjusted Debt To Equity Ratio = Total Liabilities / (Shareholder Equity + Treasury Stock)

For IBM, it looks like this: $100B / $142B = 0.70

That's quite a difference from the regular debt-to-equity ratio of 5.29. The only reason that the regular debt-to-equity ratio is so high is the large amount of treasury stock on the balance sheet, which is a sign of financial strength, and shouldn't necessarily be considered as a bad thing.

Symbol

2012

2011

2010

IBM

5.29

4.79

3.93

Table 2: Debt To Equity Ratio At IBM

Symbol

2012

2011

2010

IBM

0.70

0.73

0.76

Table 3: Adjusted Debt To Equity Ratio At IBM

From these two tables, you can see that the normal debt-to-equity ratio looks terrible and is getting worse. However, when you strip out the negative equity impact of the treasury stock, the ratio looks pretty good and is slowly improving.

Return On Equity

Like the return on assets, the return on equity helps to give you an idea as to how efficient management is with the assets that it has at its disposal. It is calculated by using this formula.

Return On Equity = Net Income / Shareholder Equity

Generally speaking, the higher this figure, the better. However, it can be misleading, as management can juice this figure by taking on lots of debt, reducing the equity. This is why the return on equity should be used in conjunction with other metrics when determining whether a stock makes a good investment. Also, it should be mentioned that some companies are so profitable that they don't need to retain their earnings, so they buy back stock, reducing the equity, making the return on equity higher than it really should be. Some of these companies even have negative equity on account of buybacks.

The return on equity for IBM is equal to $17.6B in net income, divided by shareholder equity of $18.9B, which is equal to a whopping 93.1%. However, as was the case with the debt-to-equity ratio, this unusually large figure is due largely to the financial engineering that was done through share repurchases.

To strip out the equity-reducing effect of treasury stock that I discussed earlier, here is how you can calculate what I call the adjusted return on equity.

Adjusted Return On Equity = Net Income / (Shareholder Equity + Treasury Stock)

So, the adjusted return on equity for IBM is as follows:

$17.6B / $142B = 12.4%

To illustrate how the returns on equity of IBM have changed over the last couple of years, I have created one table for the return on equity, and another for the adjusted return on equity.

Symbol

2012

2011

2010

IBM

93.1%

87.1%

64.3%

Table 4: Returns On Equity At IBM

Symbol

2012

2011

2010

IBM

12.4%

12.4%

12.4%

Table 5: Adjusted Returns On Equity At IBM

When you strip out the large effects of treasury stock, it can be seen that IBM has generated a consistent return on equity over the last three years.

Retained Earnings

Retained earnings are earnings that management chooses to reinvest into the company as opposed to paying it out to shareholders through dividends or buybacks. It is simply calculated as:

Retained Earnings = Net Income - Dividend Payments - Stock Buybacks

On the balance sheet, retained earnings is an accumulated number, as it adds up the retained earnings from every year. Growth in this area means that the net worth of the company is growing. You generally want to see a strong growth rate in this area, especially if you're dealing with a growth stock that doesn't pay much in dividends or buybacks. More mature companies, however, tend to have lower growth rates in this area, as they are more likely to pay out higher dividends.

IBM has a very impressive figure of $118B. In the table below, you can see how this figure has grown over the last three years. Over this time frame, retained earnings grew by more than 45%, which is very impressive for a mature dividend-paying company that buys back a lot of stock like IBM.

Symbol

2012

2011

2010

2009

IBM

$118B

$105B

$92.5B

$80.9B

Table 6: Retained Earnings At IBM

Conclusion

After reviewing the most recent balance sheet, it can be concluded that there is much to like about the financial condition of IBM. It has a sizeable amount of cash and short-term investments that can be used for acquisitions, debt retirement, dividends, and share repurchases, in addition to a strong level of free cash flow. A decent current ratio shows that the company can meet its short-term financial obligations, even in the event of an unlikely disruption of its operations. The company's long-term debt appears to be manageable given the company's earnings power and free cash flow generation. The company has shown very good returns on assets and returns on equity, along with good growth in retained earnings over the last three years in spite of the fact that the company has repurchased more than $25B of stock over the last couple of years.

The biggest concern that I have with IBM at this time is the fact that goodwill accounts for nearly a quarter of the company's total assets. If some of the many acquisitions that this company has made over the years don't produce the value that the company originally anticipated, then we could see asset writedowns, which may be detrimental to the stock price.

While this is not a comprehensive review as to whether IBM should be bought or sold, I think that its overall financial condition is pretty good.

To learn more about how I analyze financial statements, please visit my new website at this link. It's a new site that I created just for fun, as well as for the purpose of helping others make good financial decisions.

Thanks for reading and I look forward to your comments!

Source: A Checkup On IBM's Financial Condition